International trade is based on the principle of comparative advantage. Countries specialize in the production of goods and services in which they have a comparative advantage. They export these goods and services to other countries, and import the goods and services the other countries produce. The international marketplace has become increasingly robust, as it has become easier and more cost-effective to transport goods and services across great distances.
Review absolute and comparative advantage in the following materials.
Innovations in communications technologies and transportation have generated increased levels of international trade and globalization. Exports and imports across the globe have increased. Additional factors that have contributed to increased trade include: income levels, relative prices, the exchange rate, trade policies, consumer preferences, and technology innovation.
Net Exports = Exports – Imports
Businesses and consumers who want to import goods and services from a foreign country need to purchase a sufficient amount of foreign currency to buy the goods or services they want to import. For example, a Japanese consumer who wants to buy certain American toys and games, needs to buy enough U.S. dollars to cover the costs of the purchase.
Businesses, investors, banks, and consumers buy currencies on the foreign exchange market. Like other types of markets, the foreign exchange market is subject to the laws of supply and demand. When Japanese consumers exhibit a strong demand to buy American products and services, the price of the U.S. dollar increases.
The Market for Dollars
A shift of demand and/or supply of dollars will affect the value of the U.S. dollar. For example, a shift of the demand for dollars to the right raises the equilibrium value of the dollar (the dollar will appreciate), and vice versa.
Free trade generally increases the well-being of both trade-partners since it allows countries to specialize in producing the goods and services in which they have comparative advantage. Nevertheless, policy makers frequently argue against free trade policies, and impose trade restrictions, such as tariffs and quotas.
Consumers usually suffer when governments impose tariffs and quotas, because foreign businesses pass along any additional fees they must pay for the tariff by increasing prices. Businesses may feel less pressure to make needed improvements to gain a competitive advantage in the global marketplace—since they no longer face competition from foreign companies.
Review how trade barriers, such as tariffs and quotas affect international trade in the following resources.
International trade that operates in a free market benefits all trading partners. Exporting countries are able to sell additional goods and services, increase their economic activity, and promote employment in industries where they enjoy a comparative advantage. Consumers in importing countries have the opportunity to buy a greater variety of goods and services, that cost less than what is available in their own country. International trade allows trading partners to buy and sell goods in a marketplace beyond their own limited borders.
Figure 2.9 Production Possibilities Curves and Trade
Suppose the world consists of two continents: South America and Europe. Both produce two goods: food and computers. We assume each continent has a linear production possibilities curve (panels a and b). South America has a comparative advantage in food production. Europe has a comparative advantage in computer production.
Free trade allows the continents to operate on the bowed-out curve GHI (panel c). If the continents refuse to trade, the world operates inside its respective production possibilities curve.
For example, if each continent produces at the midpoint of its production possibilities curve, the world produces 300 food units and 300 computers at point Q during each period. However, if the world adopts a policy of free trade, so each continent can specialize in the good where it has a comparative advantage, world production can increase to point H. The world produces more food and more computers.
Review the gains from trade in Applications of the Production Possibilities Model from Principles of Macroeconomics.
Review the role of international trade in the exchange of currencies in learning outcome 7b above.